529 Contributions During College Years

Many people think that as soon as your student hits college, you should stop contributing to their 529 account. But unless you already have 100% of qualified expenses in your 529, continuing to contribute can be really beneficial as long as you follow a few guidelines. In fact, you can almost use your 529 as a super savings account. First, the guidelines:

If you’re eligible for the AOTC, don’t overcontribute such that you can’t claim the AOTC because you have to withdraw too much from your 529.

Make sure that you withdraw enough each year that you don’t incur a penalty for excess nonqualified withdrawals after graduation.

Know the rules for your state’s tax deduction. For example, in Oregon you have to have an amount in your account on Dec. 31 that is equal to or greater than the amount for which you are claiming a tax benefit that year.

Why would you put money into your 529 instead of leaving it in your checking or savings account? Let’s say you are a Michigan resident with an incoming college freshman and you plan to spend $5,000 out of pocket each year during the college years. You could just send the money directly to the school, but what if instead you first deposited it into your 529? One option is to just make deposits into the 529 on the same schedule as you’d spend the funds from your account– perhaps half in August and half in January– and then take the state tax deduction for those contributions, yielding a 4.25% return on those contributions via the tax savings. Suppose, too, that you have money in your savings account which at current rates is earning 0.03% interest. If you left it in the savings account, it would earn 0.03% x $5,000 x 0.5 (half the year remains) = $0.75 for the rest of the year. You could also transfer it to an online savings account at 1.5% interest, where you’d get $37.50 in interest the rest of 2020. Sounds great, right? But if you’re in the 22% tax bracket, federal and state taxes (4.25% in Michigan) would reduce your interest earnings to $27.65.

What if you transferred $5,000– one year’s out-of-pocket spending– from your savings into your 529 and left it there for the rest of 2020? The Michigan Education Savings Program offers a state tax deduction and a “guaranteed” account that pays 2.1%, tax-free. So your $5,000, contributed to the plan, would earn you a $212.50 tax savings plus $52.50 in tax-free interest for a total of $265– almost 10 times what you earned in the online savings account. That means you got a 5.3% rate of return on your savings. And remember, if your student is in college, you can withdraw from your 529 at any point as long as your withdrawals don’t exceed your qualified expenses, meaning you could essentially use your 529 as a tax-free savings account during the college years.

This is a highly simplified illustration but an example of why continuing to contribute to your 529 during the college years can be extremely beneficial.

P.S. My next Facebook Live interview event will be Tues., May 12, at 5:30 PDT. I’ll be discussing AP and IB classes with Jennifer Warren, an AP Spanish teacher at Evergreen High School and fellow mom of college-aged twins. To join the event, just follow The College Financial Lady on Facebook.

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The College Financial Lady

Hi, I’m Ann Garcia, CFP®, the College Financial Lady. I’m a fee-only, fiduciary financial advisor. I help families plan and finance affordable college education. I’m also a mom to college-aged twins, so I’m right there with you.

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